The Tax Cuts and Jobs Act of 2017 (the “TCJA”) included a new tax incentive for taxpayers to invest in low-income communities through deferring the recognition of gain from the sale or exchange of property if that gain is reinvested in a “qualified opportunity fund” (a “QO Fund”). A QO Fund is a fund that invests in qualifying businesses in certain low-income communities across the United States. On October 19, 2018, the Treasury Department issued highly-anticipated proposed regulations (the “Proposed Regulations”) providing critical guidance for QO Funds and potential investors in QO Funds to use this new incentive.
The incentive program is found in two sections of the Internal Revenue Code that were added by the TCJA. Section 1400Z-1 provides states with the ability to designate certain qualifying low-income communities as “qualified opportunity zones” (“QO Zones”). Section 1400Z-2 sets forth the rules governing the tax incentives available for investors in QO Funds and the qualification and operation of a QO Fund. Earlier this year, the Treasury Department released guidance for governors to nominate up to 5% of the census tracts within their state as QO Zones, and QO Zones have been approved in all 50 states, the District of Columbia and in U.S. overseas territories.
Incentives For Taxpayers
Section 1400Z-2 of the Code offers two main incentives for investors in QO Funds. First, investors are able to temporarily defer the inclusion in gross income of capital gains from the sale or exchange of assets if those gains are reinvested in a QO Fund. The gains must be reinvested in a QO Fund within 180 days of that sale or exchange (the “180-Day Reinvestment Rule”) and their inclusion in gross income is deferred until the earlier of (a) the date on which a taxpayer disposes of its investment in a QO Fund, and (b) December 31, 2026 (the “Recognition Date”). On the Recognition Date, the taxpayer will recognize gain equal to the difference between the amount of gain deferred and the taxpayer’s basis in the QO Fund investment. Second, Section 1400Z-2 gradually converts this deferral benefit into a permanent exclusion. While the taxpayer’s basis in the QO Fund investment is initially zero, if the taxpayer has held its investment for at least five years, the taxpayer’s basis increases by 10% of the deferred gain, and if the taxpayer has held its investment for at least seven years, the taxpayer’s basis increases by an additional 5% of the deferred gain. The taxpayer will recognize the deferred gains exceeding its basis in its QO Fund interest on the Recognition Date, and the amount recognized will also be added to the taxpayer’s basis in its QO Fund interest. In addition, if the taxpayer holds its investment in a QO Fund for at least 10 years, then at the time the taxpayer disposes of the investment, the taxpayer may elect to increase its basis in its QO Fund investment to its then fair market value (the “Ten-Year Election”), thereby permanently avoiding any federal income tax on the difference between the then-value of its interest in the QO Fund and the amount of gain originally deferred.
The Proposed Regulations answer a number of open questions about these incentives. Below is a high-level summary of a number of the key matters addressed in the Proposed Regulations:
Eligible Gains. Deferral is only available for gains that are “capital gains” for U.S. federal income tax purposes, those capital gains must have been required to be recognized (if not for the availability of deferral under Section 1400Z-2) and the capital gains must not arise as a result of sales of property to related persons. Under the Proposed Regulations, net capital gain from a Section 1256 contract at the end of the taxpayer’s taxable year is eligible for deferral, but net capital gain from straddles or other “offsetting positions transactions” is not eligible.
Eligible Taxpayers. All taxpayers that recognize capital gains are eligible to defer tax on those capital gains under Section 1400Z-2, including individuals, corporations (including regulated investment companies and real estate investment trusts (i.e., REITs)), partnerships, and other pass-through entities.
Eligible QO Fund Investments. Investments qualifying for the provisions of Section 1400Z-2 must be equity, and not debt, investments in QO Funds.
Partnerships. A partnership may elect to defer capital gains that it would otherwise recognize if those capital gains are invested in a QO Fund. If the partnership does not elect to do so, any of its partners may elect to defer its distributive share of the partnership’s capital gains.
180-Day Reinvestment Rule. The 180-day period for investing capital gains in a QO Zone begins on the day on which the capital gains would be recognized for U.S. federal income tax purposes if not for Section 1400Z-2 (generally on the date of the sale or exchange). In addition, if a taxpayer defers tax on a capital gain by investing its gain in a QO Fund and the taxpayer later disposes of its entire interest in the QO Fund, the taxpayer may continue to defer that gain if it invests in another QO Fund within 180 days of the date on which Section 1400Z-2 would have required the taxpayer to recognize the previously deferred gain. For a partnership, the 180-day Reinvestment Rule applies under the general rule described above. For an electing partner, the 180-day period, generally, begins at the end of the partnership’s taxable year, although partners may elect for it to begin at the same time as it does for the partnership, but only if the partner knows (i) when the partnership recognized the gain, and (ii) that the partnership will not itself elect to defer that gain under Section 1400Z-2. Unless a partner makes an election to begin the 180-day period on the date of the sale or exchange, these rules may provide the partner with meaningful additional time to invest their eligible gains.
Attributes of Deferred Gain. Capital gains deferred under Section 1400Z-2 will have the same tax attributes as the gains had at the time deferral began. For example, deferred capital gain arising from an asset the taxpayer held for less than a year will continue to be short-term capital gain after the deferral period under Section 1400Z-2 ends.
Ten-Year Election. The Proposed Regulations clarify that the Ten-Year Election is only available with respect to any investment or portion of an investment in a QO Fund for which the taxpayer deferred capital gains. In other words, the two incentives of Section 1400Z-2 work conjunctively, not separately. In addition, although the QO Zone designations under Section 1400Z-1 are set to expire on December 31, 2028, the Ten-Year Election will remain available for investments in QO Funds made as late as June 2027.
Qualifying as a QO Fund
Section 1400Z-2 also governs what investment vehicles may qualify as QO Funds. To qualify as a QO Fund, an investment vehicle must hold at least 90% of its assets in “qualified opportunity zone property” (“QO Property”). QO Property, generally, consists of “qualified opportunity zone business property” (“QO Business Property”) or equity investments in “qualified opportunity zone businesses” (“QO Business”). A QO Business is an entity, substantially all of the tangible property of which is QO Business Property, subject to certain limitations. QO Business Property is property used in a trade or business of the QO Fund or a QO Business (a) that the QO Fund or the QO Business acquires by purchase after December 31, 2017, (b) of which the QO Fund or the QO Business either is the original user or which the QO Fund or the QO Business substantially improves, and (c) substantially all of the use of which is within a QO Zone during substantially all of the time the QO Fund or QO Business holds it. “Substantial improvement” of property for this purpose means that during any 30-month period beginning after the property was acquired, the QO Fund’s or the QO Business’s basis in the property increases by an amount equal to the amount the QO Fund or the QO Business paid for the property. Thus, a QO Fund can conduct its own QO Business, or it can invest in entities that conduct a QO Business. Whether a QO Fund meets the 90% test is measured based on the average percentage of QO Property owned by the QO Fund on a semiannual basis.
The Proposed Regulations also answer some of the open questions about how to qualify as a QO Fund. Below is a summary of the key provisions:
Self-Certification. An eligible entity is able to self-certify its status as a QO Fund by attaching Form 8996 to its tax return for any year in which it qualifies as such.
Eligible Entities. Although the statute only specifies that a QO Fund must be a corporation or partnership, the Proposed Regulations clarify that any entity that is classified as a corporation or a partnership for U.S. federal income tax purposes (e.g., a multi-member limited liability company) may qualify as a QO Fund.
Pre-Existing Entities. It is not necessary for an entity to be newly-formed to qualify as a QO Fund. A pre-existing entity can qualify if it meets the necessary requirements.
Valuation Method. Whether a QO Fund satisfies the 90% test is determined based on the value of its assets as shown on the QO Fund’s applicable financial statements (as defined under Section 475(a) of the Internal Revenue Code) or, if the QO Fund does not have applicable financial statements, the cost of the assets.
Working Capital. Under certain circumstances, holding working capital in order to acquire or improve tangible property will not threaten the status of a QO Business as such.
Investing in a QO Fund provides a significant opportunity for investors to defer paying tax on their capital gains and avoid paying tax on the appreciation in the QO Fund in which those gains were reinvested. The Proposed Regulations provide welcome guidance for taxpayers looking to take advantage of that opportunity. Treasury has requested comments regarding some outstanding issues and plans to issue additional guidance in the near future, but many questions still remain unanswered. O’Melveny will be closely monitoring further developments in this area and can assist clients with analyzing and complying with the Proposed Regulations and any future guidance related to these new tax incentives.